Net interest margin securities have become a standard structure, occasionally used in various asset classes such as mortgages or (infrequently) autos.
The principal involves securitizing the residual cash flows of a trust, which imputes principal and interest portions to the cash flow, but does not explicitly distinguish between those two elements. It is critical that investors understand where they rank in the pecking order, as they will be last in line to receive any payments from the "waterfall" after the other senior and subordinated classes.
SLIMS, which apply the same concept, are poised to become successful in their own right in the student loan sector.
"We expect to see more deals soon," said Claire Mezzanotte, managing director at Fitch Ratings. "Low interest rates have been a precipitating factor in creating a plethora of consolidation loans, and consolidation predisposes itself to a NIM structure."
Along with the abundance of seasoned consolidations, mainstream investors are becoming more comfortable with the structures.
"Over the past five or six years, the market has grown to accept the product," said Adam Kaplan, associate director at Fitch Ratings.
Why are consolidated loans so useful in creating SLIMS?
"The ideal candidate as collateral for these transactions is one that throws off predictable, reliable cash flows," said Mary Kane, research analyst at Citigroup Global Markets Inc.
The consolidated loans are more stable, with less volatile prepayments, than Staffords.
That is not to say that nonconsolidated loans could not theoretically be included, said David Hartung, senior vice president at Dominion Bond Rating Service.
"But it's cleaner' if every loan in the homogenous pools is structured in the same way, and it's easier to get your arms around the excess spread," he said.
The latest arrival
Investors have responded well, appreciating that they can obtain attractive spreads compared to alternative corporate and mortgage products with longer maturities, Kane said. Also, the underlying assets are of exceptionally high quality.
Hartung mentioned a recent transaction, GCO Slims Trust, underwritten by Citigroup Global Markets. The 3.6-year, single-A transaction, based on a 100% consolidated pool, was issued out of a master trust structure, using a secondary trust to allocate the excess spread into the SLIM piece.
"It produced a high fixed-rate coupon for investors," said Hartung, referring to the
5.72% yield.
Understanding
the risks
The reduced credit risk - unlike the collateral in mortgage pools - is a particular advantage of the student loan collateral. The distinguishing feature of these loans is they are reinsured by the Department of Education, which guarantees 98% to 100% reimbursement to lenders, providing certain conditions are met. That means that defaults are really akin to prepayments.
That is not to say there are no other risks. Significant ones to be aware of are servicer, basis and prepayment risks. The loans must be originated and serviced according to Department of Education guidelines, so as not to jeopardize the guarantee. That involves sending out the requisite letters and making phone calls to borrowers.
Multiple interest rates will produce some basis risk. Though students are locked into the fixed consolidations, the government guarantees to lenders a margin of 90-day commercial paper plus 2.64%.
If CP, which is pegged to Libor, falls, "widened spreads might eat into the excess spread you have created," Kaplan said.
This is not likely, however, in a rising rate environment, and the transactions are stress-tested in any case.
While prepayment risks are low, "the speed at which any loans prepay remains a key component," Kane said. "The rate is important for pricing, as the excess spread produced is a function of the principal balance of the pool."
If the loans prepay faster, the balance dwindles, leaving less interest for investors.
Kane explained that investors receive some protection from overcollateralization and the "buffering" classes in the master trusts. Targeted amortization classes and auction rate securities are short-term products that roll over every 30 days and soak up prepayment volatility.
Why issue SLIMS?
The choice of whether to divert residual cash flows into SLIMS depends on each unique business model, and how each entity prefers to finance itself for operational or any other purposes.
"They have to take into account factors such as cost structures, or how far they want to diversify their funding sources," Mezzanotte said.
Does the issuer have a need for extra cash at a particular price, and how much would it cost by comparison to issue other types of debt?
Issuers face three alternatives. Sellers may take the money out for themselves as the deal pays down in the form of excess spread. That may involve waiting for up to 30 years. A second alternative is to accelerate the repayment of bonds, reducing the interest expenses to the trust. A third option is reissuing the cash flows as SLIMS to monetize the value of the deal. One can calculate the bonds to represent the present value of the future excess spread.
Hartung suggested some potential issuers that hold significant collateral in consolidation-only pools. Candidates include Nelnet, College Loan Corporation and Sallie Mae. He sees ample opportunities for issuances. It was essential to build a critical mass of student loans.
"The market is ripe and ready now," he said.
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